Bernanke: Obama stimulus would lift economy

updated 3:24 p.m. ET Jan. 13, 2009

LONDON - A mammoth stimulus package being crafted by President-elect Barack Obama could give the economy a much-needed lift, but other steps must be taken to bolster the wobbly financial system and for any recovery to stick, Federal Reserve Chairman Ben Bernanke said Tuesday.

Specifically, Bernanke suggested the government inject more money into banks. He also offered options to deal with rotten mortgages and other bad assets held by financial institutions, a problem that has contributed to a lockup in lending. Bernanke also again called for the government to do more to curb home foreclosures.

The Fed chief’s extensive remarks, in a speech at the London School of Economics, come at a critical time as the U.S. gets ready to change its political and economic guard from President George W. Bush to Obama next week.

Bernanke’s idea of giving more federal money to banks, and his mention of the fund’s original intent of buying up their toxic assets, could affect the argument over whether to release the second $350 billion in bailout money. Obama favors broadening the bailout program to help distressed homeowners.

“Bernanke knows there is a debate out there on how to use the second half of the bailout money, and I think his remarks will have some influence on that,” said Michael Feroli, economist at JPMorgan Economics. “I think the Obama team ... hasn’t ruled out anything in terms of ways to assist the financial sector.”

Bernanke said the roughly $800 billion stimulus package — a blend of tax cuts and increased government spending — now being worked on by Obama and the Democrat-controlled Congress could provide a “significant boost” to the crippled economy. But he made clear that such a plan must be part of a broader, multi-pronged government response to fight the worst financial crisis the hit the U.S. and the global economy since the 1930s.

“Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit,” Bernanke said. “History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.”

To help on that front, the Fed is lending billions to financial companies and buying mounds of companies’ debt to help bust through the debilitating credit clog. And the Treasury Department is overseeing a $700 financial bailout program that has pledged to inject $250 billion into banks in return for partial government ownership. Some government money also is being used to guarantee against possible losses from risky assets held by Citigroup Inc.

Bernanke said “more capital injections and guarantees may become necessary” to stabilize financial markets and spur more lending. If Obama’s incoming Treasury secretary Timothy Geithner decides to remove toxic assets from financial institutions’ balance sheets — the original but abandoned strategy under the $700 billion bailout — Bernanke suggested some options to do that.

Public purchases of the troubled assets are one way to go, he said. Another option is to provide asset guarantees under which the government would agree to absorb — presumably in exchange for warrants or some other form of compensation — part of the prospective losses on specified portfolios of rotten assets held by banks. Yet another approach would be to set up and capitalize so-called “bad banks,” which would buy assets from the financial institutions in exchange for cash and equity in the bad bank.

One of the most pressing decisions that Geithner will face is exactly how to spend the second, $350 billion installment of the bailout fund and whether to resurrect the strategy — shelved by Bush’s Treasury secretary Henry Paulson — of buying toxic assets held by banks.

Obama’s transition team had no immediate comment Tuesday, but a letter from his incoming economic adviser Lawrence Summers to congressional leaders on Monday also called for a comprehensive approach — beyond the stimulus package — to deal with the crisis.

Obama’s political skills will be put to a high-stakes test with Congress as he seeks assess to the second half of the $700 billion bailout pot. Congress has a 15-day deadline to reject the request, which Bush made on Obama’s behalf on Monday.

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